Trend Following

In my opinion, the best trading strategy for trading the Forex market is probably trend following. Different markets behave in different ways and the Foreign Exchange market is one of the few markets left that still tends to experience long and fairly clean trends.

Trend following has slowly lost it’s effectiveness as a trading strategy on most markets in the last few decades as markets generally only tend to trend well when they are being driven by real economic fundamentals and not by speculation. And as speculators have gained access to ever increasing amounts of capital over the last 20 or 30 years as more and more wealth is poured into hedge funds and the likes the influence of speculators has increased.

But speculation still doesn’t rule the Foreign Exchange market in the way that it rules equity prices. Real economic demand, central banks and national governments still seem to have way more influence over their currencies than financial speculators do, and this is of course is particularly true of the large liquid currencies such as the Euro, the British Pound and the US Dollar. Of all the currency pairs that trend well the EUR/USD probably trends the best.

Markets such as equities and most commodities do not usually trend well enough to be traded with most trend following systems. And even when a trend is in place on these markets it is not usually ‘clean’ enough to be tradeable with a normal trend following system, there is often just to much volatility there for most trend following strategies to work. Speculators usually increase a market’s volatility as they tend to drive the market to make a series of short-term dips and peaks with their gambling, even during a trend. But despite their seemingly ever increasing influence, markets like the bond market, interest rate markets and the major currency pairs such as the EUR/USD still seem to experience long lasting and fairly clean trends making them suitable for trend followers.

As a concept, trend following is incredibly simple, logical and sound (providing that the market traded is actually trending of course). The essence of trend following is the belief that once a trend is in place it is more likely to continue than not. A trend is usually detected by the market making a new, and significant, higher high (an uptrend) or a new and significant lower low (a downtrend). The trader attempts to ride the trend by going long when a new higher high is made in the hope that they will be able to sell it even higher; or go short during a downtrend in the hope that they will be able to buy the market back again even lower. Winning trades are to be left open to grow and grow, to “ride the trend until the end” as the saying goes, and losing trades are supposed to be cut off quickly before they get out of control.

It all sounds so simple and logical doesn’t it? The problem is of course that people are rarely logical. Trend following is actually incredibly difficult for most people to do, the human brain is just not wired up to cope with a trading strategy like that at all. Trend following strategies are usually medium to long-term trading strategies and sticking to a plan through thick and thin over a long period of time takes more discipline, patience and self control than most people have. Especially when it is their own money that is on the line. Buying high and selling low is also of course completely counter intuitive for most people too – most people’s emotions and intuition tells them to buy low and sell high. And cutting losses quickly is also difficult as taking a loss is never nice and the temptation is always there to hold on just a little longer in the hope that the position will turn around, but this is exactly how ones losses get out of control in the first place. Likewise whenever a profit appears the temptation is to take it while you have it, but again, trend following demands that we ride the trend until the end. And of course trend following trading strategies tend to maximise the amount one wins with a winning trade, not the number of times one wins. Trend following strategies tend to experience loss after loss during choppy market conditions and one is expected to just stick to the system at times like these and concentrate on not missing that one big trade that is supposed to come along now and again and make up for all these losses. Sticking to the plan during a string of losses that seems to never end and grinds one down is probably the hardest part of trend following for most people.

Learning to follow the trend,

For those who wish to learn the discipline and self control required for trend following I would urge them to practice the following trading strategy in a demo trading account

  1. Pick a currency pair.
  2. Look at the 15 minute, 1 hour and 4 hour charts.
  3. Is there a trend in place on all three time-frames? A trend should be immediately obvious, if it is not then it probably doesn’t exist in which case you need to go back to step one and try again with another currency pair.
  4. Place an order in the direction of the trend with an automatic stop loss and profit target. The stop loss should be above or below a recent high or low and the profit target should be at least twice the size of the stop loss, but preferably three times larger.
  5. Do not close the trade manually, always let these trades on your demo account be stopped out or hit their profit targets, whichever happens to happen first.

Following this system should, over time, help to condition ones mind to be OK with cutting losses quickly and let profits run.